Correcting Excess Contributions

Will you be conducting an annual actual deferral percentage (ADP) nondiscrimination test on your 401(k) plan and have concerns that the plan may not pass the test?

QUESTION: What should we do if our plan fails the ADP test?

ANSWER: If your plan fails, you can take corrective action to protect the plan’s qualified status.

DISCUSSION: The ADP test compares the average rate at which highly compensated employees defer salary with the average deferral rate for nonhighly compensated employees. The difference between the averages for the highly paid and lower paid employees must be within certain limits.

If your plan fails testing, you need to take corrective action. The three ways to make corrections are:

Distribute excess contributions to highly compensated employees within 12 months after the end of the plan year. A 10% excise tax generally will apply to any excess contributions that are not distributed within the first 2½ months of the new plan year. For plans that are “eligible automatic contribution arrangements” and cover all eligible employees, corrective contributions can be made up to six months following the end of the plan year without incurring the excise tax.

Recharacterize the excess contributions as after-tax contributions within 2½ months of the plan’s year-end.